CHAPTER 8 Managing in Competitive, Monopolistic, and Monopolistically Competitive Markets Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter Outline Chapter Overview Perfect competition Demand at the market and firm levels Short-run output decisions Long-run decisions Monopoly Monopoly power Sources of monopoly power Maximizing profits Implications of entry barriers Monopolistic competition Conditions for monopolistic competition Profit maximization Long-run equilibrium Implications of product differentiation Optimal advertising decisions 8-2
Introduction Chapter Overview Chapter 7 examined the nature of industries, and saw that industries differ with respect to their structures, conducts and performances. This chapter focuses on how managers determine the optimal price, quantity and advertising decisions in the following market environments: Perfect competition. Monopoly. Monopolistic competition. 8-3
Key Conditions Perfect Competition Perfectly competitive markets are characterized by: The interaction between many buyers and sellers that are small relative to the market. Each firm in the market produces a homogeneous (identical) product. Buyers and sellers have perfect information. No transaction costs. Free entry into and exit from the market. The implications of these conditions are: a single market price is determined by the interaction of demand and supply firms earn zero economic profits in the long run. 8-4
Perfect Competition Demand at the Market and Firm Levels In Action Price Market Price Firm S PP ee DD ff = PP ee D 0 Market output Firm s output 8-5
Short-Run Output Decisions Perfect Competition The short run is a period of time over which some factors of production are fixed. To maximize short-run profits, managers must take as given the fixed inputs (and fixed costs), and determine how much output to produce by changing the variable inputs. 8-6
$ Short-Run Profit Maximization: Revenue-Cost Approach In Action Slope of RR = MMMM = PP A Maximum profits E B Costs CC QQ Perfect Competition Revenue RR = PP QQ Slope of CC QQ = MMCC 0 QQ Firm s output 8-7
Competitive Firm s Demand The demand curve for a competitive firm s product is a horizontal line at the market price. This price is the competitive firm s marginal revenue. DD ff = PP = MMMM Perfect Competition 8-8
Perfect Competition Short-Run Profit Maximization In Action $ MMMM AAAAAA PP ee AAAAAA QQ Profit DD ff = PP ee = MMMM 0 QQ Firm s output 8-9
Competitive Output Rule Perfect Competition To maximize profits, a perfectly competitive firm produces the output at which price equals marginal cost in the range over which marginal cost is increasing. PP = MMMM QQ 8-10
Perfect Competition Competitive Output Rule In Action The cost function for a firm is CC QQ = 5 + QQ 2. If the firm sells output in a perfectly competitive market and other firms in the industry sell output at a price of $20, what price should the manager of this firm charge? What level of output should be produced to maximize profits? How much profit will be earned? Answer: Charge $20. Since marginal cost is 2QQ, equating price and marginal cost yields: $20 = 2QQ QQ = 10 units. Maximum profits are: ππ = 20 10 5 + 10 2 = $95. 8-11
Short-Run Loss Minimization In Action Perfect Competition $ MMMM AAAAAA AAAAAA AAAAAA QQ PP ee Loss DD ff = PP ee = MMMM 0 QQ Firm s output 8-12
$ The Shut-Down Case In Action MMMM Perfect Competition AAAAAA AAAAAA AAAAAA QQ AAAAAA QQ PP ee Loss if shut down Fixed Cost DD ff = PP ee = MMMM Loss if produce 0 QQ Firm s output 8-13
Short-Run Output Decision Perfect Competition To maximize short-run profits, a perfectly competitive firm should produce in the range of increasing marginal cost where PP = MMMM, provided that PP AAAAAA. If PP < AAAAAA, the firm should shut down its plant to minimize it losses. 8-14
Perfect Competition Short-Run Firm Supply Curve In Action PP 1 $ Short-run supply curve for individual firm MMMM AAAAAA PP 0 0 QQ 0 QQ 1 Firm s output 8-15
Firm s Short-Run Supply Curve Perfect Competition The short-run supply curve for a perfectly competitive firm is its marginal cost curve above the minimum point on the AAAAAA curve. 8-16
Market Supply Curve In Action Perfect Competition P Individual firm s supply curve MMMM ii Market supply curve S $12 $10 0 1 500 Market output 8-17
Perfect Competition Long-Run Decisions: Entry and Exit In Action Price SS 2 Price PP 2 PP 0 DD ff = PP 0 = MMMM 0 PP 1 SS 0 EExxxxxx EEnnnnnnnn SS 1 Exit Entry DD ff = PP 2 = MMMM 2 DD ff = PP 1 = MMMM 1 D 0 Market output 0 Firm s output 8-18
Long-Run Competitive Equilibrium In Action $ Perfect Competition MMMM Long-run competitive equilibrium AAAA PP ee DD ff = PP ee = MMMM 0 QQ Firm s output 8-19
Long-Run Competitive Equilibrium In the long run, perfectly competitive firms produce a level of output such that PP = MMMM PP = mmmmmmmmmmmmmm oooo AAAA Perfect Competition 8-20
Monopoly and Monopoly Power A market structure in which a single firm serves an entire market for a good that has no close substitutes. Sole seller of a good in a market gives that firm greater market power than if it competed against other firms. Implication: market demand curve is the monopolist s demand curve. However, a monopolist does not have unlimited market power. Monopoly 8-21
Monopolist s Demand In Action Monopoly Price Monopolist s power is constrained by the demand curve. PP 0 A PP 1 B DD ff = DD MM 0 QQ 0 QQ 1 Output 8-22
Sources of Monopoly Power Monopoly Economies of scale Economies of scope Cost complementarity Patents and other legal barriers 8-23
Elasticity of Demand and Total Revenues In Action Monopoly Price Revenue Elastic Maximum revenues PP 0 QQ 0 Unitary PP 0 Unitary RR 0 Total Revenue Curve Inelastic Elastic Inelastic D 0 QQ 0 MR Q 0 QQ 0 Firm s output 8-24
Marginal Revenue and Elasticity The monopolist s marginal revenue function is MMMM = PP 1 + EE EE, where EE is the elasticity of demand for the monopolist s product and PP is the price charged. For PP > 0 MMMM > 0 when EE < 1. MMMM = 0 when EE = 1. MMMM < 0 when 1 < EE < 0. Monopoly 8-25
Marginal Revenue and Linear Demand Given an linear inverse demand function PP QQ = aa + bbbb, where aa > 0 aaaaaa bb < 0, the associated marginal revenue is MMMM QQ = aa + 2bbbb Monopoly 8-26
Marginal Revenue In Action Monopoly Suppose the inverse demand function for a monopolist s product is given by PP = 10 2QQ. What is the maximum price per unit a monopolist can charge to be able to sell 3 units? What is marginal revenue when QQ = 3? Answer: The maximum price the monopolist can charge for 3 units is: PP = 10 2 3 = $4. The marginal revenue at 3 units for this inverse linear demand is: MMMM = 10 2 2 3 = $2. 8-27
Output Rule Monopoly A profit-maximizing monopolist should produce the output, QQ MM, such that marginal revenue equals marginal cost: MMMM QQ MM = MMMM QQ MM 8-28
Monopoly Costs, Revenues, and Profit In Action $ CC QQ Cost function RR = PP QQ QQ Revenue function Slope of RR = MMMM Maximum profit Slope of CC QQ = MMMM 0 QQ MM Output 8-29
Profit Maximization In Action Monopoly Price PPPPPPPPPPPPPP = PP MM AAAAAA QQ MM QQ MM MC ATC PP MM AAAAAA(QQ MM ) Profits QQ MM MR Demand Quantity 8-30
Pricing Rule Monopoly Given the level of output, QQ MM, that maximizes profits, the monopoly price is the price on the demand curve corresponding to the QQ MM units produced: PP MM = PP QQ MM 8-31
Monopoly In Action Monopoly Suppose the inverse demand function for a monopolist s product is given by PP = 100 2QQ and the cost function is CC QQ = 10 + 2QQ. Determine the profit-maximizing price, quantity and maximum profits. Answer: Profit-maximizing output is found by solving: 100 4QQ = 2 QQ MM = 24.5. The profit-maximizing price is: PP MM = 100 2 24.5 = $51. Maximum profits are: ππ = $51 24.5 10 + 2 24.5 = $1,190.50. 8-32
Monopoly Absence of a Supply Curve Recall, firms operating in perfectly competitive markets determine how much output to produce based on price (PP = MMMM). Thus, a supply curve exists in perfectly competitive markets. A monopolist s market power implies PP > MMMM = MMMM. Thus, there is no supply curve for a monopolist, or in markets served by firms with market power. 8-33
Multiplant Decisions Monopoly Often a monopolist produces output in different locations. Implications: manager has to determine how much output to produce at each plant. Consider a monopolist producing output at two plants: The cost of producing QQ 1 units at plant 1 is CC QQ 1, and the cost of producing QQ 2 at plant 2 is CC QQ 2. When the monopolist produces a homogeneous product, the per-unit price consumers are willing to pay for the total output produced at the two plants is PP QQ, where QQ = QQ 1 + QQ 2. 8-34
Multiplant Output Rule Monopoly Let MMMM QQ be the marginal revenue of producing a total of QQ = QQ 1 + QQ 2 units of output. Suppose the marginal cost of producing QQ 1 units of output in plant 1 is MMMM 1 QQ 1 and that of producing QQ 2 units in plant 2 is MMMM 2 QQ 2. The profit-maximizing rule for the two-plant monopolist is to allocate output among the two plants such that: MMMM QQ = MMMM 1 QQ 1 MMMM QQ = MMMM 2 QQ 2 8-35
Implications of Entry Barriers Monopoly A monopolist may earn positive economic profits, which in the presence of barriers to entry prevents other firms from entering the market to reap a portion of those profits. Implication: monopoly profits will continue over time provided the monopoly maintains its market power. Monopoly power, however, does not guarantee positive profits. 8-36
Monopoly Zero-Profit Monopolist In Action Price MC ATC PP MM = AAAAAA(QQ MM ) QQ MM MR Demand Quantity 8-37
Deadweight Loss of Monopoly Monopoly The consumer and producer surplus that is lost due to the monopolist charging a price in excess of marginal cost. 8-38
Monopoly Deadweight Loss of Monopolist In Action Price PP MM PP CC MC Deadweight loss MR Demand QQ MM QQ CC Quantity 8-39
Monopolistic Competition Monopolistic Competition: Key Conditions An industry is monopolistically competitive if: There are many buyers and sellers. Each firm in the industry produces a differentiated product. There is free entry into and exit from the industry. A key difference between monopolistically competitive and perfectly competitive markets is that each firm produces a slightly differentiated product. Implication: products are close, but not perfect, substitutes; therefore, firm s demand curve is downward sloping under monopolistic competition. 8-40
Price Profit-Maximizing Monopolistically Competitive Firm In Action PPPPPPPPPPPPPP = PP AAAAAA QQ QQ MC ATC Monopolistic Competition PP AAAAAA(QQ ) Profits QQ MR Demand Quantity 8-41
Profit-Maximization Rule Monopolistic Competition To maximize profits, a monopolistically competitive firm produces where its marginal revenue equals marginal cost. The profit-maximizing price is the maximum price per unit that consumers are willing to pay for the profit-maximizing level of output. The profit-maximizing output, QQ, is such that MMMM QQ = MMMM QQ and the profit-maximizing price is PP = PP QQ. 8-42
Long-Run Equilibrium If firms in monopolistically competitive markets earn short-run Monopolistic Competition profits, additional firms will enter in the long run to capture some of those profits. losses, some firms will exit the industry in the long run. 8-43
Price Entry in Monopolistically Competitive Market In Action MC Monopolistic Competition ATC PP Due to entry of new firms selling other brands Demand 1 Demand 0 QQ MR 1 MR 0 Quantity of Brand X 8-44
Long-Run Monopolistically Price MC Monopolistic Competition Competitive Equilibrium In Action Long-run monopolistically competitive equilibrium ATC PP Demand 1 QQ MR 1 Quantity of Brand X 8-45
Long-Run and Monopolistic Competition In the long run, monopolistically competitive firms produce a level of output such that: PP > MMMM PP = AAAAAA > mmmmmmmmmmmmmm oooo aaaaaaaaaaaaaa cccccccccc Monopolistic Competition 8-46
Implications of Product Differentiation The differentiated nature of products in monopolistically competitive markets implies that firms in these industries must continually convince consumers that their products are better than their competitors. Two strategies monopolistically competitive firms use to persuade consumers: Comparative advertising Niche marketing Monopolistic Competition 8-47
Optimal Advertising Decisions Optimal Advertising Decisions How much should a firm spend on advertising to maximize profits? Depends, in part, on the nature of the industry. The optimal amount of advertising balances the marginal benefits and marginal costs. Profit-maximizing advertising-to-sales ratio is: AA RR = EE QQ,AA EE QQ,PP 8-48
Conclusion Firms operating in a perfectly competitive market take the market price as given. Produce output where PP = MMMM. Firms may earn profits or losses in the short run. but, in the long run, entry or exit forces economic profits to zero. A monopoly firm, in contrast, can earn persistent profits provided that the source of monopoly power is not eliminated. A monopolistically competitive firm can earn profits in the short run, but entry by competing brands will erode these profits in the long run. 8-49